Financial markets generally afford the opportunity for investors to purchase an asset in order to achieve some degree of profitability. Investment vehicles such as stocks, trusts, mutual funds, pension funds, money markets, and bonds represent example investment instruments that offer investors a choice for allocating capital. One investment vehicle that has enjoyed sustained success, increased notoriety, and the prospect for optimal yields is the futures contract.
A futures contract is an agreement to buy or to sell a specific quantity of some asset at some time in the future, whereby the price of the asset is agreed upon at the time the agreement is made. Any asset whose future price is uncertain is a candidate for a futures contract. Example assets include government issued bonds, corn, wheat, cotton, coffee, cocoa, pork bellies, gasoline, heating oil, lumber, live cattle, gold, silver, yen, pounds, pesos, marks, T-bills, Eurodollar CDs, or any other suitable asset or commodity.
In any given marketplace, there are generally enough consumers and producers who want to diminish the price uncertainty (hedgers) and enough other traders willing to take on that risk (speculators) in order for the futures contract to be successful, i.e., worthwhile for the contract to be listed on a futures exchange.
Unlike a stock, which represents equity in a company and an asset that can be held for a long time, (if not indefinitely), a futures contract generally has a finite life. A futures contract can be used for hedging commodity price-fluctuation risks or for taking advantage of price movements, rather than for the buying or selling of the actual cash commodity. The word “contract” is used to describe a futures arrangement because a futures contract requires delivery of the commodity at a stated time in the future unless the contract is liquidated before it expires.
A buyer of a futures contract (the party having a long position) can agree on a fixed purchase price to buy the underlying commodity (wheat, gold or T-bills, for example) from the seller at the expiration of the contract. The seller of a futures contract (the party having a short position) can agree to sell the underlying commodity to the buyer at expiration at the fixed sales price. As time passes, the contract's value changes relative to the fixed price at which the trade was initiated. This creates profits or losses for the trader. In most cases, delivery associated with the futures contract does not take place. Instead, both the buyer and the seller, acting independently of each other, usually liquidate their long and short positions before the contract expires.
The endeavor of futures contracts is generally a zero-sum equation. Futures contracts are marked to market daily. A futures contract generally has no value when purchased or sold initially. During a given trading day, as the price fluctuates, the futures contract will take on value depending on whether the market price rises or falls and whether the trader was long (bought the contract) or short (sold the contract). Whatever gain or loss that was achieved during the day is added to or subtracted from the trader's account at the end of each trading day.
Futures trading is highly leveraged. For example, the price change on a $1,000,000 Eurodollar CD can be controlled with a margin of about only $700. These margins are not a down payment on the contract. The margins are good faith deposits against an adverse change in price. The loss on a futures contract can be much greater than the margin. If the loss is greater than the funds in the trader's account, the trader must put in more money. Such a payment is normally triggered by a ‘margin call’ issued by the trading exchange.